What is the Ability to Pay Principle?

Definition: Ability to pay principle is the concept that individuals shouldn’t be required to pay taxes beyond their wherewithal to pay the taxes. In other words, it’s a concept that determines the proportional amount of tax levied on an individual based on his or her income and capability affording the taxes.

What Does Ability to Pay Principle Mean?

What is the definition of the ability to pay principle? This principle seeks to impose a higher tax on people with a higher income and a lower tax on people with a lower income, ceteris paribus. This way lower income people aren’t taxed excessive amounts relative to their overall income.

This is the fundamental principle in the progressive tax system of the United States, which seeks income redistribution. The amount of money spent by wealthy consumers is higher than their basic necessities. Conversely, the amount of money spent by lower-income consumers is lower than their basic necessities. With this concept, the lower-income people can meet their tax obligations because they are lower than those of the higher-income people.

This concept also extends beyond simple tax brackets and income levels. For instance, individuals shouldn’t be taxed on transactions in which they don’t receive any cash. An example of this is stock options. An employee who is granted stock options receives something of value that is subject to taxation, but because they didn’t receive any cash, they can delay the tax on the options until they cash them in.

Let’s look at an example.

Example

Michael works as a bass-boy at a fine dining restaurant and earns an annual income of $36,800. Brandon is a chief financial analyst with an annual income of $225,000. The government seeks to raise the tax rates in order to collect more money towards lowering government debt. On the other hand, the progressive tax system requires higher tax rates on people like Brandon and lower tax rates on people like Michael.

Michael and Brandon belong to different tax brackets. Michael belongs to 15% tax bracket for an income between $37,650 and $91,150, and Brandon belongs to 33% tax bracket for an income between $190,150 and $413,350. With the introduction of the ability to pay principle, Brandon, who earns more than $75,000 annually, will pay 100% of the taxes, which is $225,000 x 33% = $74,250. Michael, who earns less than $75,000 annually, will pay 25% of the tax, which is $36,800 x 15% = $5,520 x 25% = $1,380.

Although the ability to pay principle makes sense, there are arguments against, mainly because it is difficult to accurately determine a person’s ability to pay taxes. Furthermore, the government imposes a tax on the income earned, not on the marginal utility of each consumer.

Summary Definition

Define Ability to Pay Principle: The wherewithal to pay concept is a taxation principle that suggests people shouldn’t be subjected to taxes that they aren’t able to pay based on their income.